2012 0213 adobe report

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Great research update from Cowen on Adobe.

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2012 0213 adobe report

  1. 1. Software Adobe Systems Initiating With Outperform (1) Asset Value Trumps Business Model TransitionFebruary 13, 2012 DiscountAnalysts Conclusion: Initiating coverage on ADBE with an Outperform. As the sayingPeter Goldmacher goes, "50% of marketing spend works, you just never know which 50%". With the(415) 646-7206peter.goldmacher arrival of Big Data, marketing departments are on the cusp of being able to@cowen.com correlate marketing spend with revenue. If marketing can quantify hard dollar returns for its programs by connecting all the links in the digital chain, weJoe del Callar believe marketing technology budgets could grow materially. Adobe, the top(415) 646-7228joe.delcallar@cowen.com brand in marketing technology, is very well positioned to benefit from this secular trend. However, the company has a lot of work to do to get from here to there. Adobe is in the midst of a business model transition focused on growth by changing its distribution and pricing models. This introduces real risk in the intermediate term to earnings and is compounded by the need to fill in some important holes in the product line up. While we share investor concerns that ADBE may not be able to make this transition quickly, we believe that there are a myriad of potential acquirers that could benefit from accelerating Adobes transition away from the glare of the public markets. Lots of Moving Parts; Challenges and Opportunities. ADBE is approximately two quarters into a multi year business model transition away from channel sales for mature products and desktop pricing models towards direct sales for growth products and subscription revenues for Digital Media. Street confidence in this transition is low and forecasting revenues and profitability during this transition is difficult. Additionally, we believe Adobe needs to build out its offerings to include Social Media and broader lead generation solutions. If Adobe can put together a comprehensive suite that can create, execute, monitor and quantify multi channel digital marketing campaigns, we are confident that marketing as a discipline will be willing to spend more money on technology that can quantify the tangible benefit of money invested in marketing programs. We believe hypothetical fair value in a takeout is > $50/shr. ADBE trades at 13x CY12 EPS estimates of $2.44 (+6%) with an 8% FCF yield.ADBE (02/10) $32.21 Revenue $MMMkt cap $16.0B FY 2011 2012E 2013EDil shares out 496.3MM Nov Actual Prior Current Prior CurrentAvg daily vol 2,803.3K Q1 1,027.7 —— 1,052.7 —— ——52-wk range $22.7-36.0 Q2 1,023.2 —— 1,099.6 —— ——Dividend Nil Q3 1,013.2 —— 1,085.7 —— ——Dividend yield Nil Q4 1,152.2 —— 1,172.8 —— ——BV/sh $11.65 Year 4,216.3 —— 4,410.7 —— 4,785.2Net cash/sh $2.82 EV/S —— —— 3.3x —— 3.0xDebt/cap 20.8%ROIC (LTM) 11.6%5-yr fwd NA OpEPS $growth (Norm) FY 2011 2012E 2013E Nov Actual Prior Current Prior Current Q1 0.58 —— 0.57 —— —— Q2 0.55 —— 0.60 —— —— Q3 0.55 —— 0.59 —— ——S&P 500 1342.6 Q4 0.67 —— 0.66 —— —— Year 2.35 —— 2.42 —— 2.67 P/E —— —— 13.3x —— 12.1xPlease see addendum of this report for important disclosures. www.cowen.com
  2. 2. Adobe Systems Table of Contents Page Executive Summary ................................................................................... 4 Company Background ...................................................................................... 4 Transforming the Business............................................................................... 5 A Takeout Target? ............................................................................................ 9 Valuation ................................................................................................ 10 Return on Invested Capital Analysis ........................................................ 11 Financials................................................................................................ 12 Recent Results and Guidance ......................................................................... 12 Revenue Dynamics and Seasonality ................................................................ 12 Profitability Dynamics and Seasonality............................................................ 13 Investment Positives ............................................................................... 14 Investment Risks..................................................................................... 16 Big Growth Opportunity Offset by Many (Smaller) Concerns .................... 19 Management Guidance: Exceeds Consensus Revenue, Possibly Conservative .................................................................................................. 19 The Realignment: An Overview ....................................................................... 22 Digital Media: Hiking Prices, Gaining Users in a Delicate Transition to Subscription Pricing ....................................................................................... 22 Digital Marketing: Revenue Growth Tempered by a Shrinking Legacy Enterprise Business ........................................................................................ 31 New Segment 1: Digital Media................................................................. 38 End Market Opportunity ................................................................................. 38 Customer Profile ............................................................................................ 39 Products ........................................................................................................ 40 Revenue and Revenue Cyclicality .................................................................... 44 Go to Market Strategy .................................................................................... 46 Competition ................................................................................................... 48 New Segment 2: Digital Marketing .......................................................... 54 End Market Opportunity ................................................................................. 54 Customer Profile ............................................................................................ 552 February 13, 2012
  3. 3. Adobe Systems Products ........................................................................................................ 56 Revenue and Sensitivity to the Macro Environment ......................................... 60 Go to Market Strategy .................................................................................... 62 Competition ................................................................................................... 62Segment 3: Print and Publishing.............................................................. 71 End Market Opportunity and Customers ......................................................... 71 Products ........................................................................................................ 71 Growth Strategy ............................................................................................. 72 Competition ................................................................................................... 73 February 13, 2012 3
  4. 4. Adobe Systems Executive Summary Company Background Founded in 1982 with a product called Postscript, a language used to control graphics and type on printers, Adobe has grown into a $4B global provider of marketing software solutions used by enterprises and consumers to create, manage, deliver and analyze digital content for desktops, tablets, smart phones and other media channels. Over half of the company’’s revenues are generated from outside the US. The company has historically leveraged acquisitions to broaden its product portfolio. The two most prominent acquisitions include the 2005 $3.4B acquisition of competitor Macromedia (Shockwave, which contributed to Flash) and the 2009 acquisition of web marketing analytics provider Omniture for $1.8B. Its two most recent acquisitions which are included in guidance, Day Software (Communiqué/CQ) and Demdex, were completed in October 2010 and January 2011, respectively. Its acquisition of Efficient Frontier was completed in January 2012, but is not yet in guidance. The company is in the process of streamlining its go to market strategy around its higher growth core offerings for the creation, distribution and analysis of digital content. The company intends to de-emphasize slower growth products in favor of larger, more contemporary product sales, which is a necessary but complex change management exercise fraught with risk. The two main segments are as listed below, followed by its smaller, less important segment: • Digital Media. The company’’s content creation segment, which includes products like Creative Suite and Photoshop, is undergoing a transformation from a predominantly up front license model to a subscription model. The goal of this change is to improve revenue visibility and catalyze new customer growth as a subscription pricing scheme theoretically drives a higher lifetime value of a customer while simultaneously attracting new customers with a lower initial price point. However, the company is not changing the delivery model from desktop to SaaS so the tangible benefit to the customer of this new pricing model is unclear. Managing this transition is very tricky and will likely lead to volatility in the model. Digital Media is sold primarily via channels and is 73% of Adobe’’s revenue. • Digital Marketing. The company’’s Digital Marketing effort will focus on Adobe’’s Omniture marketing analytics and Day web content execution products. Sales and marketing spend will be consolidated from other slower-growth Enterprise segment products to focus on these two core product sets that are expected to grow over 20% per year through FY14. The shift of S&M spending away from the company’’s other enterprise products such as its traditional content management and collaboration (LiveCycle and Connect) products that were growing, albeit likely more slowly, is expected to cause revenue from these products to decline. However, we believe the set up for margin expansion, even as sales of some products decline, is good as more focused marketing efforts should help ADBE reduce its higher than industry average S&M expenses as a percentage of sales. The company is also making a relatively small transition (compared to the Digital Media) of the $100M Day business from license to subscriptions. Digital Marketing is sold through a direct sales force and is 22% of Adobe’’s revenue.4 February 13, 2012
  5. 5. Adobe Systems• Print and Publishing. The Print and Publishing segment includes legacy products like ColdFusion and FrameMaker, and generates about 5% of sales. We do not expect management to invest much time or effort into these businesses.Excluding the $570M revenue contribution from its acquired Day and Omnitureunits, revenue has been flat since FY08 at about $3.6B, including the CS5 productcycle. It’’s reasonable to expect that the CS6 product cycle, expected to start 1H12,could provide a catalyst for the stock.The goal of the restructuring is to drive high single, low double digit growth byemphasizing the fast growing Day and Omniture units and the higher life time valueenabled by the change to subscription pricing in Digital Media business. Investorsshould expect volatility in the model as Adobe embarks on the delicate transitionfrom desktop to subscription pricing.In this initiation, we outline the investment opportunity and risk in Adobe’’stransformation and then delve into the transition in more detail. We then provide abackground on the company and each of the new segments.Transforming the Distribution and Pricing ModelAdobe is in the process of making two significant transformations: reorganizing itsfour main lines of business into two more focused business units and shifting to asubscription revenue model. There is also a slightly less far-reaching shift in S&Mspending in the new Digital Marketing segment that could help continue stronggrowth, but at the expense of existing lower-growth revenue streams. We discussthese major transformations here.The New Revenue SegmentsAdobe is realigning 95% of its business into two segments that the company istransforming for higher growth.• Digital Media. This segment (73% of FY11 revenue) services customers’’ needs in the creation, management and delivery of data from digital sources, including digital documents, websites, photos and video. This new segment includes Adobe’’s former Creative & Interactive segment, and the Knowledge Worker sub segment of the former Digital Enterprise segment.• Digital Marketing. This segment (22% of FY11 revenue) serves enterprise’’s needs to drive revenue through digital media channels including websites, mobile and IP TV. Products and services allow users to analyze digital media traffic and deliver the most appropriate content to maximize the chances of converting a visitor into a paying customer. This new segment includes Omniture and much of Adobe’’s Enterprise sub segment (part of the former Digital Enterprise segment), centered on Adobe’’s Omniture web analytics and Day CQ web content management products.The company will continue its low-growth Print & Publishing segment (5% of FY11revenue) roughly unchanged.February 13, 2012 5
  6. 6. Adobe SystemsAdobe Revenue Segments Digital Enterprise Old Revenue Segment Omniture Creative and Interactive Digital Media Print and Publishing Enterprise Knowledge Worker New Revenue Segment Digital Marketing Document Services Digital Media Creatives Print and Publishing Source: Cowen and Company, Company Reports. These mappings are only roughly correct, as there are some nuances in how the company reassigned products to each of the revenue segments. We believe that while this reorganization could be beneficial, it is an operational risk that only serves to complicate the other major transition the company is undergoing. The Transition to Subscriptions In conjunction with the realignment above, the company aims to transition its revenue model from roughly 15% recurring revenue in FY11 to 40% recurring by FY14. In order to accomplish this, Adobe is taking two steps: • In Digital Media: Broadly introducing subscription pricing for its Creative products with the Creative Cloud release (CS6, in 1H12) and adding more subscription based products (e.g., SendNow) to its Document Services line. The transition from shrink-wrap pricing to subscription pricing will materially increase ARPU. The company anticipates that subscriptions to the Creative Suite (CS) will yield an average monthly revenue per user of $40, higher than the average monthly revenue per user of $30 for perpetual licenses. • In Digital Marketing: Aggressively investing to grow its subscription-based Omniture business and transitioning its $100M Day business to subscription pricing. These two businesses are expected to grow over 30% in FY12 and over 20% in FY13 and FY14. While we do not doubt that the 33% hike in ARPU built into its Digital Media subscription pricing will build the company’’s revenue stream over time, the aforementioned target of 40% of revenue to recurring by FY14 does imply very strong growth in the Digital Media segment’’s recurring revenue, as our rough revenue breakout shows below. 6 February 13, 2012
  7. 7. Adobe SystemsAdobe Revenue Breakout: Before and After Transition to Subscription ($M) $6,000 $5,324 Digital Marketing: Non- $126 recurring $5,000 Digital Marketing: $1,012 $4,216 Recurring $4,000 $413 $496 $1,100 Digital Media: Recurring $154 $3,000 $2,000 $2,934 Digital Media: Non- $2,899 recurring $1,000 $0 Print and Publishing FY11 FY14E Source: Cowen and Company. Company Reports.Investors may be concerned that guidance implies a $900M increase in Digital Mediaover three years driven by 8x growth in Digital Media’’s recurring revenue streams, aseemingly difficult feat. Given that Digital Media sales increase $600M-$800M in theNTM after a Creative Suite release (except for the unfortunately timed mid-recessionCS4 release), this would imply a significant portion of would-be perpetual licenseshrink-wrap purchasers opting for subscriptions instead.We infer that the model above, based on guidance provided by managementsummarized in the table that follows, requires somewhere between 25% and 70% ofcustomers to make subscription purchases instead of shrink wrap softwarepurchases. Our range is unusually wide as the lack of product, customer and pricemix, and additional variance introduced by the range of Document Servicesscenarios make determining a smaller range infeasible. Our analyses are shown onpp. 28-29.FY11 Results and Guidance for FY12-FY14 FY11 Revs Segment Guidance (Reported) FY12 FY13-FY14 "Core" Digital Marketing $577 20%+ 20%+ LiveCycle and Web Conferencing $333 -$150M Decline Digital Marketing $910 3%-4% Creatives $2,347 10-12% Document Services $741 8-10% Digital Media $3,088 5%-7% Print and Publishing $218 Total Revenue $4,216 4%-6% EPS $2.35 $2.37-$2.47 Source: Cowen and Company, Company Reports.February 13, 2012 7
  8. 8. Adobe Systems The transition to subscription pricing in the upcoming CS6/Creative Cloud product cycle (projected release in 1H12) mutes the revenue growth one would expect from a typical CS release cycle (see chart below). Guided growth for Digital Media of 5%-7% in FY12 implies a lift of only $150M-$200M, compared to nearly $600M for CS5 and $800M for CS3. If Adobe’’s customers choose to purchase shrink wrap software instead of software subscriptions, the company could actually significantly outperform revenue guidance in FY12, at the price of lower revenue growth in FY13 and FY14.Digital Media Revenue Before and After Recent Creative Suite Releases ($M) $3,500 $180 $798 ($506) $600 $3,000 $2,500 12 mos Revenue ($M) $2,000 $1,500 $1,000 $500 $2,139 $2,937 $3,061 $2,556 $2,363 $2,955 $3,090 $3,270 2Q06-1Q07 2Q07-1Q08 4Q07-3Q08 4Q08-3Q09 2Q09-1Q10 2Q10-1Q11 2Q11-1Q12E 2Q12E-1Q13E $0 CS3 CS4 CS5 CS6 (E) Creative Suite Release 12 mos Before 12 mos After Source: Cowen and Company, Company Reports. While Digital Media revenues dropped after the release of CS4, we discount this data point somewhat as it was launched in the teeth of the 2008 recession to tepid reviews. The Digital Marketing Spending Shift In a related and slightly less far-reaching transformation, management is reallocating S&M spend in the Digital Marketing segment from its slower-growing legacy enterprise business of enterprise document management and collaboration to its fast-growing Omniture and Day (web content management) businesses. The net effect of this shift is that the company expects an immediate $150M decline in the legacy enterprise business in FY12 and continued subsequent declines in this business. 8 February 13, 2012
  9. 9. Adobe SystemsDigital Marketing Revenue Outlook $1,400 $1,200 $1B in Omniture and Day 3%-4% Total FY12 Revenue Combined Revenue Growth (~30% Omniture and Day $1,000 Revenue Growth) $800 $577 $600 $400 $150 Decline from S&M Shift $200 $333 Legacy Enterprise Revenue Declines $0 FY11 FY12 FY13 FY14 Legacy Enterprise Revenue (LiveCycle and Web Conferencing) Core Marketing (Day + Omniture) Source: Cowen and Company, Company Reports.The upside to this shift is that more efficient S&M spend could help improveoperating margins in this business, with a tangible effect on ADBE’’s bottom line (p.37).A Takeout Target?We believe that multiple acquirers could benefit from Adobe’’s existing portfolio andthat the business can benefit from transitioning Adobe away from the glare of thepublic markets.The table below shows recent takeout multiples for similarly-sized software firms.The average takeout multiples are considerably higher than the multiples Adobetrades at today.Recent Takeout Multiples ($MM, except per share data) EV/NTM NTM EV/NTMDate Acquiree Acquiror EV NTM Revs Revs EBITDA EBITDA12/13/2004 PeopleSoft Oracle $8,930.2 $2,829.8 3.2x $614.7 14.5x 9/13/2005 Siebel Oracle $3,714.3 $1,295.3 2.9x $157.3 23.6x 10/8/2007 Business Objects SAP AG $5,489.0 $1,524.7 3.6x $322.9 17.0x 1/16/2008 BEA Oracle $7,184.0 $1,630.8 4.4x $416.7 17.2x 5/12/2010 Sybase SAP AG $6,100.3 $1,258.6 4.8x $457.7 13.3x 8/19/2010 McAfee Intel Corporation $7,680.0 $2,133.3 3.6x $203.2 37.8x 8/18/2011 Autonomy PLC HP $10,500.0 $1,185.3 8.9x $641.5 16.4xHigh 8.9x 37.8xLow 2.9x 13.3xAverage 4.5x 20.0x Adobe $14,588.1 $4,411.1 3.3x $1,843.5 7.9x Source: Cowen and Company. Thomson One IBES.February 13, 2012 9
  10. 10. Adobe Systems Valuation At the moment, Adobe is predominantly a traditional license model, and as such should be valued on its EPS multiple. Exiting FY14, the company expects roughly 40% of its revenue to be recurring. At that point, it should be re-evaluated for possible re-valuation based on its FCF multiple. Adobe currently trades at a premium to the group PEG, at 13x consensus CY12 EPS of $2.44 for 6% growth, compared to the group multiple of 15x for 9% growth.Application Software Company Valuation ($MM, except per share data) As of 02/10/12 PF CY12E Stock Market PF CY12E PE / Ent. PF CY12E CY12E EBITDA EV/ Growth CY12 FCF CY12 Op Ticker Rating FYE Price Value EPS P/E Growth Growth Value Rev EV/Rev Growth FCFF EV/FCFF Growth EBITDA Yield Margin Adobe Systems ADBE 1 Nov $32.21 $15,985 $2.44 13x 6% 2.1x $14,588 $4,411 3.3x 7% $1,337 11x 0% $1,844 8x 5% 8.4 % 37.5 % JDA Software Grp JDAS NC Dec $26.52 $1,128 $2.34 11x 8% 1.4x $1,107 $713 1.6x 6% N/A NM N/A $195 6x 9% N/A 23.0 % Manhattan Assoc. MANH NC Dec $45.66 $945 $2.53 18x 14 % 1.3x $846 $367 2.3x 11 % $53 16x 6% $87 10x 19 % 5.6 % 21.9 % Microsoft * MSFT 1 Jun $30.50 $255,918 $2.84 11x 8% 1.4x $215,657 $76,638 2.8x 7% $26,112 8x (2%) $31,954 7x 7% 10.2 % 37.6 % MicroStrategy MSTR NC Dec $122.72 $1,337 $3.07 40x 71 % 0.6x $1,137 $638 1.8x 13 % $60 19x 172 % $64 18x 77 % 4.5 % 6.1 % Oracle ORCL 2 May $28.49 $145,954 $2.48 12x 9% 1.3x $129,720 $38,449 3.4x 4% $12,939 10x 2% $18,253 7x 6% 8.9 % 46.6 % QADA 1 Jan $13.81 15x QAD ** $230 $0.95 9% 1.6x $172 $256 0.7x 5% $26 7x 12 % $28 6x 9% 11.3 % 9.0 % QADB 1 Jan $13.81 15x SAP + SAP 3 Dec $62.90 $74,851 $4.06 15x 8% 2.0x $72,123 $20,694 3.5x 9% $4,844 15x 9% $7,740 9x 9% 6.5 % 33.1 % Perpetual license vendors Median 15x 9% 1.4x 2.3x 7% 12x 7% 7x 9% 7.7 % 23.0 % High 40x 71 % 2.0x 3.5x 13 % 19x 172 % 18x 77 % 11.3 % 46.6 % Low 11x 8% 0.6x 0.7x 4% 7x (2%) 6x 6% 4.5 % 6.1 % Ariba ARBA 1 Sep $29.64 $2,908 $1.00 30x 19 % 1.6x $2,686 $545 4.9x 18 % $70 38x 73 % $127 21x 28 % 2.4 % 20.1 % Aspen Technology AZPN 1 Jun $20.97 $2,018 $0.05 NM NM NM $1,911 $263 7.3x 34 % $88 22x 28 % ($5) NM NM 4.3 % 1.9 % Concur Tech CNQR NC Sep $55.34 $3,017 $0.91 61x 12 % 5.2x $2,790 $464 6.0x 27 % $47 60x 12 % $109 25x 15 % 1.5 % 18.7 % Constant Contact CTCT 1 Dec $30.63 $939 $0.89 35x 31 % 1.1x $800 $251 3.2x 18 % $22 36x (6%) $46 17x 28 % 2.4 % 11.3 % DealerTrack TRAK 1 Dec $28.79 $1,223 $1.09 27x 11 % 2.4x $1,159 $383 3.0x 10 % $68 17x (19%) $85 14x 14 % 5.6 % 18.9 % Intuit INTU 1 Jul $56.70 $17,010 $3.09 18x 15 % 1.2x $16,458 $4,393 3.7x 10 % $836 20x 12 % $1,626 10x 9% 4.9 % 33.2 % Kenexa KNXA 1 Dec $28.17 $786 $1.03 27x 24 % 1.1x $688 $357 1.9x 24 % $32 21x (2%) $57 12x 20 % 4.1 % 10.7 % NetSuite N NC Dec $45.40 $3,082 $0.21 NM 40 % NM $2,940 $299 9.8x 27 % $38 77x 41 % $29 NM 26 % 1.2 % 5.8 % Red Hat * RHT 2 Feb $47.97 $9,265 $1.13 42x 11 % 4.0x $8,456 $1,250 6.8x 19 % $335 25x 5% $357 24x 16 % 3.6 % 25.3 % Salesforce.com CRM 3 Jan $128.44 $18,260 $1.60 80x 22 % 3.6x $17,458 $2,906 6.0x 32 % $412 42x 19 % $534 33x 37 % 2.3 % 12.6 % SuccessFactors SFSF NC Dec $39.97 $3,365 $0.11 NM NM NM $3,117 $420 7.4x 26 % $36 86x 104 % $20 NM (8%) 1.1 % 3.1 % Taleo TLEO NC Dec $45.65 $1,894 $1.13 40x 10 % 4.1x $1,783 $380 4.7x 17 % $44 41x 86 % $76 24x 1% 2.3 % 14.1 % Subscription vendors Median 35x 17 % 2.4x 5.5x 21 % 37x 16 % 21x 16 % 2.4 % 13.4 % High 80x 40 % 5.2x 9.8x 34 % 86x 104 % 33x 37 % 5.6 % 33.2 % Low 18x 10 % 1.1x 1.9x 10 % 17x (19%) 10x (8%) 1.1 % 1.9 % All apps Median 27x 12 % 1.5x 3.5x 17 % 22x 12 % 13x 14 % 4.2 % 18.7 % High 80x 71 % 5.2x 9.8x 34 % 86x 172 % 33x 77 % 11.3 % 46.6 % Low 11x 8% 0.6x 0.7x 4% 7x (19%) 6x (8%) 1.1 % 1.9 % Rating system: 1 = Outperform, 2 = Neutral, 3 = Underperform, NC = not covered by Cowen. Restd = Restricted. Estimates are current First Call Consensus estimates when available, Cowen ests provided otherwise. * Covered by Gregg Moskowitz; ests from First Call Consensus ** QAD figures are for the composite of QAD Class A and QAD Class B shares where applicable + SAP financials converted at a rate of $1.3277/Euro Source: Cowen and Company, First Call Consensus Estimates. 10 February 13, 2012
  11. 11. Adobe SystemsReturn on Invested Capital AnalysisGiven the rough CS4 product release during the recession that began in 2008, it isnot surprising that the company’’s ROIC took a hit during the recession, whichprimarily hit FY09, going from the mid-teens to the high-single digits. ROIC climbedin FY11 to the double digits with a better CS5 and CS5.5 cycle and we believe it willcontinue to climb if the company is able to hit its revenue goals during the currentbusiness model transformation.ADBE ROIC FY08A FY09A FY10A FY11A FY12E FY13E EBIT (excl. other income) $1,451.8 $1,018.0 $1,386.6 $1,593.0 $1,653.3 $1,813.8 + Implied interest from operating leases 89.8 88.4 105.2 61.7 47.3 38.4 Adjusted operating profits before taxes $1,541.6 $1,106.3 $1,491.7 $1,654.7 $1,700.6 $1,852.1 Income tax expenses $333.5 $248.2 $333.3 $333.8 $358.1 $397.8 + Decrease (-Increase) in deferred tax liabilities 64.7 (119.8) 51.7 18.8 (0.8) (15.9) + Increase (-Decrease) in deferred tax assets 66.0 (33.3) 5.8 8.7 - - + Tax benefits of net interest expense 11.8 9.8 (15.3) (24.5) (27.3) (22.0) + Tax benefits of interests on operating leases 31.4 30.9 36.8 21.6 16.5 13.4 - Tax on other income (5.7) 5.9 2.1 (2.0) (1.7) (2.2) Cash operating taxes $501.8 $141.8 $414.5 $356.4 $344.9 $371.1 NOPAT $1,039.8 $964.6 $1,077.2 $1,298.3 $1,355.7 $1,481.0 Book value of common stock $4,410.4 $4,890.6 $5,192.4 $5,783.1 $6,998.8 $8,366.1 + Deferred tax liabilities 150.3 270.2 218.4 199.6 200.4 216.3 - Deferred tax assets (110.7) (77.4) (83.2) (92.0) (92.0) (92.0) + Accumulated goodwill amortization 2,349.7 4,022.0 4,170.6 4,394.7 4,289.1 4,194.6 + Long term debt 350.0 1,000.0 1,513.7 1,505.1 1,497.1 1,489.1 + Capitalized lease obligations - - 8.8 9.2 9.2 9.2 + PV of operating leases 1,496.4 1,472.6 2,428.1 1,425.3 1,091.3 885.3 - Excess cash (20% of rev rule) 1,303.2 1,315.3 1,708.0 2,068.4 3,376.2 4,804.0 Invested Capital $7,342.8 $10,262.6 $11,740.7 $11,156.7 $10,617.7 $10,264.6 ROIC 14.2% 9.4% 9.2% 11.6% 12.8% 14.4% Source: Cowen and Company, Company Reports.February 13, 2012 11
  12. 12. Adobe Systems Financials Recent Results and Guidance The company reported FY11 (November) EPS of $2.35(+22%) on revenue of $4.2B (+11%). The company guided 1Q12 to EPS of $0.54 to $0.59 on revenue of $1.025B- $1.075B. Management guided FY12 to EPS of $2.37 to $2.47 on revenue of $4.385B- $4.47B. Revenue Dynamics and Seasonality Most of Adobe’’s major products, particularly those in the new Digital Media unit that currently account for roughly 73% of the company’’s revenue, have a release coordinated around the company’’s Creative Suite (CS) bundle. Hence, one would expect Adobe’’s revenue to wax and wane with its product cycles. This is evident in the chart below.Adobe Revenue Growth Generally Driven by Product Cycles $2,500 100% CS1 CS2 CS3 CS4 CS5 CS5.5 80% $2,000 60% 43% 41% 42% 39% 37% 34% 34% 34% 33% 40% 28%27% 28% 22% 21%21% 19% 24% 20% 17% 19% 20% Revenue ($M) $1,500 11% 12% 12% 9% 8% 20% Growth (%) 8% 4% 2% 1% (1%) 0% (12%) 0% (17%) (21%) (21%) $1,000 (20%) (40%) $500 (60%) (80%) $0 (100%) 1Q03A 2Q03A 3Q03A 4Q03A 1Q04A 2Q04A 3Q04A 4Q04A 1Q05A 2Q05A 3Q05A 4Q05A 1Q06A 2Q06A 3Q06A 4Q06A 1Q07A 2Q07A 3Q07A 4Q07A 1Q08A 2Q08A 3Q08A 4Q08A 1Q09A 2Q09A 3Q09A 4Q09A 1Q10A 2Q10A 3Q10A 4Q10A 1Q11A 2Q11A 3Q11A 4Q11A Major Creative Release Adobe Revenue Y/Y Growth Source: Cowen and Company, Company Reports. We note that Adobe typically exhibits strong revenue growth starting one to two quarters after a major release of Creative Suite and subsequently ebb. The exception to this pattern was observed after the October 2008 release of Creative Suite 4 (CS4), which was unfortunately timed from a macro perspective. However, the company ostensibly returned to the historical pattern after the release of CS5. CS6 is due in the first half of calendar year 2012, roughly around April, in FY 2Q12. 12 February 13, 2012
  13. 13. Adobe Systems Profitability Dynamics and Seasonality Not surprisingly, we find that Adobe’’s earnings are also driven by product cycles, other than the tough CS4 cycle that was marred by a recession and products generally not as well received as other releases in the past.Adobe EPS Growth Also Generally Driven by Product Cycles $1.25 100% CS1 CS2 CS3 CS4 CS5 CS5.5 80% $1.00 60% 43% 41% 42% 39% 34% 34% 37% 34% 33% 28% 27% 28% 40% 22% 21% 21% 19% 24% 20% 17% 19% 20% Earnings ($M) $0.75 11% 12% 12% 20% Growth (%) 9% 8% 8% 1% 4% 0% 2% (1%) (12%) 0% (21%) (17%) (21%) $0.50 (20%) (40%) $0.25 (60%) (80%) $0.00 (100%) 1Q03A 2Q03A 3Q03A 4Q03A 1Q04A 2Q04A 3Q04A 4Q04A 1Q05A 2Q05A 3Q05A 4Q05A 1Q06A 2Q06A 3Q06A 4Q06A 1Q07A 2Q07A 3Q07A 4Q07A 1Q08A 2Q08A 3Q08A 4Q08A 1Q09A 2Q09A 3Q09A 4Q09A 1Q10A 2Q10A 3Q10A 4Q10A 1Q11A 2Q11A 3Q11A 4Q11A Major Creative Release Adobe Earnings Y/Y Growth Source: Cowen and Company, Company Reports. February 13, 2012 13
  14. 14. Adobe Systems Investment Positives 50% of Marketing spend is effective. Adobe will be able to tell Marketers which 50% is working. Our overarching thesis for owning Adobe is that marketing as a discipline is on the cusp of transitioning from an art to a science. No longer solely the domain of the creative types, as marketing accelerates its move online, marketers now have the tools to quantify the benefit of their marketing dollars. We believe this dynamic is going to drive a transition in marketing spend where efficient spending is paramount and marketers increase spend on content and tools that can quantify the returns on marketing investments. Reorganized business segments are focusing company on the $14B Digital Marketing and complementary content opportunity. Adobe used to have five (or six, depending on who’’s counting) business units that seemed to chase every conceivable micro-segment of the market. The company has since reorganized down to two core units: Digital Marketing and Digital Media. We believe this will emphasize the role of the company’’s products in the enterprise marketing process, and support this process with its content creation products. Mature legacy products continue in its Print & Publishing segment. We believe this renewed focus will help the company develop into the one-stop software shop for enterprise marketing departments, a $14B market, much like what Salesforce.com is to sales departments today. Shift in S&M spend to support the Day and Omniture Digital Marketing units is expected to stimulate Digital Marketing revenue growth post- FY12. Combined, Adobe’’s Omniture and Day units are growing their top line over 20% per year, and the company is shifting its investments to these units from slower-growing units to continue this rapid growth. Although the realignment of sales and marketing resources will result in an initial revenue decline in its legacy enterprise business of $150M, the company expects the resource reallocation to help continue growing its current $600M marketing Omniture and Day business at a rate of over 20% per year to a $1B business by FY14. We quantify the upside from this and the subscription shift in Digital Media in a later section beginning on p. 19. Margin expansion opportunity in the Digital Marketing segment. We estimate that sales & marketing spend for the company’’s Digital Marketing business is at around 30%, well above the low-20% norm of large software companies that sell to the enterprise such as Microsoft, Oracle and even SAP. Conservatively assuming this upside only applies to Digital Marketing, its primary enterprise business, this can lead to 200 bps of margin improvement, or up to 15c upside to Adobe’’s current FY14 earnings of about $2.97. The aforementioned decision to focus on Omniture and Day is a strategy change from selling everything to everyone (Development tools? Collaboration? Manage web/external content? Manage internal content? Instrument your marketing? Sure we got that!) to focusing on more relevant products for a specific audience. The Digital Marketing specialist vs. the enterprise generalists. In the Digital Marketing space, Adobe faces competition from bigger, better-heeled competitors such as Oracle, Microsoft, IBM and HP/Autonomy. While these competitors can offer steeper discounts when bundling their competing Digital Marketing solutions with other offerings, we believe the success enjoyed by Omniture (pre- and post-Adobe), by Salesforce.com in the CRM space and by several14 February 13, 2012
  15. 15. Adobe Systemscompanies in the HR/Recruiting Automation space suggests that specialists canthrive within the enterprise in their department-level niches.Strong Digital Media product family. Adobe’’s family of content creationproducts is the de facto standard for editing media (““Photoshop”” is a verb inWebster’’s English dictionary) and we estimate it accounts for roughly a third of therevenue currently generated in the space with the remaining revenue shared amongover 20 competitors such as Apple, Microsoft and Corel.Underpenetrated global Digital Media market. While Adobe is the clearmarket leader in Digital Media and accounts for about a third of the revenue in thespace, we believe there is still headroom for growth in the space. We estimateAdobe’’s (paid) product penetration among its target users is only about 35%. Manyof these users may actually be using unpaid (aka pirated) Adobe software, but mayconvert to paid users when Adobe’’s license checking functionality (discussed below)is rolled out.Shift in Digital Media to subscription pricing is designed to catalyzerevenue growth. Excluding the education vertical, the company recentlyintroduced subscription pricing in its predominantly desktop license based DigitalMedia segment that is set up to increase average revenue per user (ARPU) over timewhile attracting new users by lowering the initial cost of owning the product. Thesuccessful small market test of subscriptions on its Creative Suite products, wherethe company observed a 33% hike in revenue and observed that 38% of users signingon were new customers, has led the company to roll this pricing model out morebroadly. With the lower price of entry, the company hopes to add 800K new usersfrom FY15, an improvement from the flat installed base management claims hasbeen the status quo for several years. We quantify the potential upside from this,along with the shift in emphasis in the Digital Marketing unit, in a later sectionbeginning at p. 19.Subscription pricing should help smooth out revenue seasonality.Historically, the company’’s revenue dipped and rose with its Creative Suite (CS)product cycle (p. 12). The transition to a subscription revenue model should helpsmooth out this seasonality. The company expects to introduce the next majorrelease CS6 in 1H12, likely in April (fiscal 2Q12).Roll out of SaaS integrations in CS6 (““Creative Cloud””) can help revenuegrowth. In addition to a shift to subscription pricing, the company’’s CS6 releasewill include SaaS functionality (such as on line storage) to be called ““the CreativeCloud”” that we believe can help revenue by forcing would-be freeloaders to becomepaying customers, and providing the company with more information on customerbehavior for cross-selling and up-selling. Quantification of these opportunities arebeyond the scope of this note as the company unfortunately does not providedetailed enough information to determine up-sell and cross-sell potential, andpotential conversion of users who gravitate to pirated software.February 13, 2012 15
  16. 16. Adobe Systems Investment Risks Business transitions are not easy. The reallocation of sales & marketing spend in the Digital Marketing division and the shift to a subscription model in the Digital Media segment represent a significant transition with a likely negative impact on revenue in the short term. Management expects the license-to- subscription shift in its Digital Media segment and a $150M negative revenue impact expected from a reallocation of S&M spend from low-growth to higher-growth businesses in its Digital Marketing segment to reduce FY12 revenue by 4%-5%, resulting in revenue growth of 4%-6% next fiscal year. Overall the company expects the revenue contribution of recurring revenue streams such as maintenance and subscriptions to climb from an estimated 15% today (recurring revenues are more than what is currently reported on the income statement) to about 40% in three years. As we showed on p. 7, this implies very strong growth in the Digital Media segment’’s recurring revenue. Upheaval possible in customer base. In its Digital Marketing segment, the company is likely to lose some of its legacy enterprise product customers (e.g., LiveCycle and Connect) from a transition of investments to high-growth marketing analytics and web content management products. Revenue from these legacy products in Digital Marketing is expected to drop from about $330M in FY11 to $180M in FY12. In its other primary segment, Digital Media, too heavy a hand in forcing new subscription pricing could risk alienating existing customers that are used to purchasing on a shrink wrap license basis. Business model transition may put stock in the doldrums. When it started a similar transition from perpetual to subscription, Ariba had its stock drop from the mid teens to the mid single digits, and did not sustain pre-transition levels until over two years later. And while the Internet Bubble burst during its transition, we note that CA’’s stock was essentially flat over the five years since its transition. We do note that AZPN has so far successfully managed to grow its share price during (despite?) the transition, but we also note that the company is concurrently improving its cash flow situation during the same period.16 February 13, 2012
  17. 17. Adobe SystemsARBA, CA and AZPN Share Prices from the Beginning of their Model TransitionsARBA $20 $18 $16 $14 $12 $10 $8 $6 $4 $2 $0 04 05 06 08 4 5 5 8 8 9 9 5 6 6 6 8 9 7 7 7 07 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 20 20 20 20 20 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 0/ 0/ 0/ 0/ 0/ 30 30 30 30 30 30 30 30 30 30 30 30 30 30 30 30 /3 /3 /3 /3 /3 9/ 3/ 6/ 9/ 3/ 6/ 9/ 3/ 6/ 9/ 3/ 6/ 9/ 3/ 6/ 9/ 12 12 12 12 12CA $45 $40 $35 $30 $25 $20 $15 $10 $5 $0 00 03 04 01 02 2 4 4 5 0 1 1 5 5 1 2 2 3 3 3 4 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 20 20 20 20 20 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 9/ 9/ 9/ 9/ 9/ 29 29 29 29 29 29 29 29 29 29 29 29 29 29 29 29 /2 /2 /2 /2 /2 9/ 3/ 6/ 9/ 3/ 6/ 9/ 3/ 6/ 9/ 3/ 6/ 9/ 3/ 6/ 9/ 12 12 12 12 12AZPN $25 $20 $15 $10 $5 $0 09 10 11 9 9 0 0 0 1 1 1 00 00 01 01 01 01 01 01 20 20 20 /2 /2 /2 /2 /2 /2 /2 /2 0/ 0/ 0/ 30 30 30 30 30 30 30 30 /3 /3 /3 6/ 9/ 3/ 6/ 9/ 3/ 6/ 9/ 12 12 12 Source: Cowen and Company, Company Reports.Meandering strategy. The company has had three realignments over the lastfive years. Not only does this make it difficult to understand the historicalperformance of the segments, it may also signal a lack of a steady hand fordeveloping a stronger presence in the enterprise market, which is likely needed ifthe company aims to grow 20% in its digital marketing products. Given this trackrecord, investors may also be leery of management’’s fortitude to follow through onFebruary 13, 2012 17
  18. 18. Adobe Systems what will likely be a difficult multi-year transition in the business in terms of both products emphasized and revenue model. There are important gaps in the product line up that need to be filled. The company’’s suite still lacks solutions for proactive marketing execution, such as marketing campaign execution, email marketing and identifying leads for sales, although it has gone a long way to plug some of these holes with its purchase of display ad placement and execution platform Efficient Frontier. On the Social Media front, we believe that company would be well served to augment its analytics business with actual content. Marketing Analytics on old infrastructure. Omniture, the marketing analytics platform that is a central component in the company’’s plans to grow Digital Marketing at a 20% annual clip in the future, still primarily uses Oracle databases for its backbone, opening it to more cost-effective competition from entrants that use more contemporary Big Data solutions. HTML5 likely drags growth a bit. Many major industry players have thrown their support behind HTML5 which provides support for some of the multimedia functionality that was previously the bailiwick of Flash. In response, Adobe has also decided to support HTML5 (concurrently with Flash) and has discontinued development of Flash on mobile platforms. We do not believe that the loss of near- monopoly status in Flash will be a major drag on revenue, given that Adobe’’s tools are used to produce content in many formats (e.g., Premiere is used to produce both regular MPEG video files and Flash video that is used by sites that need digital rights management). However, we believe guide for 10%-12% growth in Digital Media revenue, including price hikes built into new subscription pricing, could have been slightly higher as some customers who primarily use Adobe tools for Flash could be enticed to switch cheaper HTML5 alternatives.18 February 13, 2012
  19. 19. Adobe SystemsBig Growth Opportunity Offset by Many (Smaller)ConcernsOther than a $570M contribution from acquisitions, Adobe’’s revenue has beenstagnant for the last three years, although the company had a bit of a recovery tostage 11% nearly all-organic revenue growth in FY11.The company did a significant realignment of its business segments and is makingsignificant shifts within these new segments to stimulate growth.• In Digital Marketing: Adobe is shifting investments to emphasize its fast growing Day and Omniture electronic marketing units.• In Digital Media: Adobe is shifting to a subscription-based pricing model that has an implicit 33% price hike with supplemental SaaS services (such as giving users space to share their files on line).While we believe that these changes have the potential to catalyze double-digitrevenue growth, the major segment realignment and the switch to subscriptionpricing in Digital Media are fraught with execution risk, while the investmenttransition in Digital Marketing has not-insignificant near term revenue downsideassociated with it.In this section, we first look at the revenue opportunity as framed by management,and then we provide details on the mechanics, benefits and risks associated with therealignment and each of the new segments.Management Guidance: Exceeds Consensus Revenue,Possibly ConservativeIn Digital Media, management expects the increase in ARPU that it is instituting withthe subscription pricing change to catalyze revenue growth after FY12. For DigitalMarketing, it expects additional investments in its Omniture and Day businesses tocontinue the strong revenue growth of the products (30% in FY11). Management hasprovided the following guidance.FY11 Results and Guidance for FY12-FY14 FY11 Revs Segment Guidance (Reported) FY12 FY13-FY14 "Core" Digital Marketing $577 20%+ 20%+ LiveCycle and Web Conferencing $333 -$150M Decline Digital Marketing $910 3%-4% Creatives $2,347 10-12% Document Services $741 8-10% Digital Media $3,088 5%-7% Print and Publishing $218 Total Revenue $4,216 4%-6% EPS $2.35 $2.37-$2.47 Source: Cowen and Company, Company Reports.February 13, 2012 19
  20. 20. Adobe Systems The guidance above implies Adobe would grow revenue at a 3-year CAGR in the high-single to low-double digit range through FY14. This guidance is generally above consensus which calls for a 7.5% 3-year CAGR through FY14, as shown below. Adobe in FY14 Based on Midpoint of Revenue Guidance $6,000 Total; $5,324 Total; $4,817 $5,000 Total; $4,422 Total; $4,216 Consensus; $5,216 Consensus; $4,787 $4,000 Consensus; $4,407 Consensus; $4,216 $3,999 $3,000 $3,618 $3,088 $3,274 $2,000 $1,000 $910 $941 $1,001 $1,138 $0 FY11 FY12 FY13 FY14 Print and Publishing Digital Marketing Digital Media Consensus Source: Cowen and Company, Company Reports. The analysis below shows the sensitivity of the FY14 revenue model to the growth of Omniture and Day in Digital Marketing and the growth in the Creative revenue with three scenarios for average decline of the legacy enterprise and Print & Publishing businesses in FY13 and FY14. We assume consensus revenues of $4.41B (+5%) for FY12, which is very slightly below the midpoint of management’’s guidance.20 February 13, 2012

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